After the completion of fundraising, private equity funds often require the target company or its major shareholder/actual controller to provide certain protections for the fund upon the occurrence of certain conditions after investment. This gives rise to the transaction arrangement of a valuation adjustment mechanism (VAM) repurchase between the private equity fund and the invested target company. With the development of private equity funds and the evolving attitude of China’s judicial adjudication towards them, the transaction arrangement for private equity fund VAM repurchases has gone through several common models.

In the earliest stage, private equity funds, as a “borrowed” concept, also drew upon the experience of foreign private equity investments by directly using the target company as the obligor for the VAM repurchase. This had its rationale, as the fund invests in the target company and the funds flow into the target company for its development purposes. Since 2013, with the vigorous development of private equity funds, disputes in judicial adjudication over the target company directly acting as the repurchase obligor have gradually increased. The target company directly serving as the repurchase obligor conflicts with China’s long-standing principle of “capital maintenance,” yet it also has its rationality in transaction arrangements. During this period, judicial adjudication remained inconclusive – from the “Haifu Case” to the “Huagong Case.” Ultimately, the Minutes of the National Conference on Civil and Commercial Trial Work (Fa [2019] No. 254, i.e., the “Jiumin Minutes”) recognized in principle the legal validity of a “VAM” between a private equity fund and the target company, acknowledging the dual status of the private equity fund as both a creditor and a shareholder. However, regarding the performance of the “VAM agreement,” it also took into account the protection of the interests of the company and its external creditors, requiring that the target company complete the capital reduction procedure when the private equity fund requests the target company to repurchase equity, and that the target company has distributable profits when the fund requests cash compensation.

Although the aforementioned Jiumin Minutes recognized the issue of validity, in practice, it is extremely difficult to truly complete the fund exit path through operations. Therefore, up to the present, a widely adopted fund repurchase transaction arrangement by investors is for the actual controller/major shareholder/management of the target company to act as the fund’s repurchase obligor, while the target company provides a guarantee for the repurchase obligations of the aforementioned parties. Putting aside whether the fund can truly exit at the financial level, this arrangement can basically achieve a legal exit path with no fundamental obstacles. However, with the increase in dispute cases, we have observed that the target company’s guarantee is often rendered illegal or invalid, resulting in the target company not bearing the guarantee liability for the major shareholder’s repurchase obligation. This article, combined with judicial precedent cases, provides a brief analysis of this and proposes countermeasures.

PART/ 01

Relevant Legal Basis

Article 15, paragraphs 2 and 3 of the Company Law (2023 Revision) provide: “Where a company provides a guarantee to a shareholder or actual controller of the company, it shall be subject to a resolution of the shareholders’ meeting.

The shareholder referred to in the preceding paragraph or the shareholder controlled by the actual controller referred to in the preceding paragraph shall not participate in the vote on the matters specified in the preceding paragraph.

Such vote shall be passed by more than half of the voting rights held by other shareholders present at the meeting.”

Article 7 of the Interpretation of the Supreme People’s Court on the Application of the Guarantee System of the Civil Code of the People’s Republic of China (Fa Shi [2020] No. 28, hereinafter the “Guarantee System Interpretation”) provides: “If the legal representative of a company, in violation of the Company Law’s provisions on the company’s resolution procedures for external guarantees, exceeds his authority to represent the company and enters into a guarantee contract with a counterparty, the People’s Court shall handle the matter in accordance with Articles 61 and 504 of the Civil Code: (1) If the counterparty is in good faith, the guarantee contract shall be effective against the company; the counterparty’s request for the company to assume the guarantee liability shall be supported by the People’s Court.

(2) If the counterparty is not in good faith, the guarantee contract shall not be effective against the company; the counterparty’s request for the company to bear compensation liability shall be handled by reference to the relevant provisions of Article 17 of this Interpretation. If the legal representative, by providing a guarantee in excess of authority, causes losses to the company, the company’s request for the legal representative to bear compensation liability shall be supported by the People’s Court.

For the purposes of the first paragraph, ‘good faith’ means that the counterparty did not know and should not have known that the legal representative was exceeding his authority at the time of entering into the guarantee contract. If the counterparty has evidence to prove that it has reasonably reviewed the company’s resolution, the People’s Court shall presume that it acted in good faith, unless the company has evidence to prove that the counterparty knew or should have known that the resolution was forged or altered.”

3.

Article 17 of the Guarantee System Interpretation: Where the principal contract is valid but the guarantee contract provided by a third party is invalid, the People’s Court shall determine the guarantor’s liability for compensation by distinguishing different circumstances: (1) If both the creditor and the guarantor are at fault, the compensation liability borne by the guarantor shall not exceed one-half of the portion of the debt that the debtor cannot discharge;

(2) If the guarantor is at fault but the creditor is not at fault, the guarantor shall bear compensation liability for the portion of the debt that the debtor cannot discharge; (3) If the creditor is at fault but the guarantor is not at fault, the guarantor shall not bear compensation liability. Where the principal contract is invalid, resulting in the invalidity of the guarantee contract provided by a third party, and the guarantor is not at fault, it shall not bear compensation liability;

If the guarantor is at fault, the compensation liability it bears shall not exceed one-third of the portion of the debt that the debtor cannot discharge.

Article 8 of the Guarantee System Interpretation: Under any of the following circumstances, if a company argues that it should not bear the guarantee liability on the grounds that it has not passed a resolution in accordance with the Company Law’s provisions on external guarantees, the People’s Court shall not support it:

(1) A financial institution issues a letter of guarantee or a guarantee company provides a guarantee; (2) A company provides a guarantee for its wholly-owned subsidiary’s business operations; (3) The guarantee contract is signed by shareholders who alone or jointly hold more than two-thirds of the voting rights on the guarantee matter.

Where a listed company provides an external guarantee, the provisions of items (2) and (3) of the preceding paragraph shall not apply.

PART/ 02

Legal Analysis of the Validity of a Company Providing a Guarantee for a Shareholder or Actual Controller in a Fund Repurchase

In the retrial case of Guo Lihua v. Shanxi Bang’ao Real Estate Development Co., Ltd. regarding equity transfer disputes (Supreme People’s Court (2017) Supreme People’s Court Civil Ruling No. 3671), the Supreme People’s Court held that the Company Law stipulates that shareholders shall not withdraw their capital contributions after the company is established. If the company provides a guarantee for equity transfers between shareholders, it could result in the company paying the transfer price to the transferring shareholder first when the acquiring shareholder fails to pay the equity transfer price, thereby harming the interests of the company and its other creditors. This would constitute a situation where shareholders indirectly withdraw their capital contributions through equity transfers, violating the Company Law’s prohibition on withdrawal of capital contributions. Ultimately, the Supreme People’s Court found that the lower court’s ruling that Bang’ao Company should bear joint and several liability for Guo Lihua’s repayment obligation was erroneous in applying the law and lacked sufficient evidence for certain findings. It instructed the Shanxi High People’s Court to retry the case.

However, there are also cases decided by the Supreme People’s Court that support the validity of a target company’s guarantee for a shareholder’s repurchase obligation. In the famous case of Qiang Jingyan v. Shandong Hanlin Company regarding capital increase, Qiang Jingyan entered into an equity transfer contract with shareholder Cao Wubo, and Hanlin Company provided a guarantee for shareholder Cao Wubo. However, Cao Wubo and Hanlin Company failed to perform their payment obligations. In the first instance, the Chengdu Intermediate People’s Court, and in the second instance, the Sichuan High People’s Court, although differing in their reasons, both held that the Hanlin Company guarantee was invalid. The Supreme People’s Court granted retrial of the case and issued a final judgment on September 7, 2018, holding that the Hanlin Company guarantee was valid. The specific reasons are as follows:

Article 16 of the Company Law (as amended in 2013) had already clarified: “Where a company provides a guarantee to a shareholder or actual controller of the company, it must be subject to a resolution of the shareholders’ meeting or the general meeting of shareholders.” From the respective reasoning of the three levels of courts, it can be seen that the important facts examined by the courts are two points: first, whether there is a shareholders’ meeting resolution, and second, whether the interests of creditors are harmed. In the Hanlin case, the court of second instance’s starting point of harming creditors’ interests was essentially consistent with the aforementioned Supreme People’s Court Case No. 3671. However, in the Supreme People’s Court Case No. 128, the court found that the interests of creditors were not harmed.

In 2019, the Jiumin Minutes stated that when the target company directly acts as the repurchase obligor, “if there are no other grounds affecting the validity of the contract, it shall be deemed valid.” Subsequently, applying the principle of “a fortiori” (weightier matters imply lesser ones), it is now generally accepted that where the target company acts as the guarantor for the repurchase obligation of the actual controller/controlling shareholder, its legal validity is essentially recognized. In the absence of any other grounds affecting the validity of the contract, the target company’s assumption of guarantee liability for the repurchase obligation of the actual controller/major shareholder is deemed valid.

PART/ 03

Common Manifestations of Defects in the Target Company’s Guarantee

01

Investment by Means of Equity Transfer, Without a Shareholders’ Meeting Resolution

When the fund initially invests and signs the repurchase agreement, the fund may not have paid attention to the fact that the target company’s guarantee for the repurchase obligation of the actual controller or shareholder requires a resolution of the target company’s shareholders’ meeting. Therefore, the target company’s guarantee is defective because there is no shareholders’ meeting resolution.

The provisions on procedural requirements for external guarantees were added when the Company Law was amended in 2005, and the 2023 revision made little change to the original clauses. According to Article 15 of the Company Law (2023 Revision), where a company provides a guarantee to a shareholder or actual controller of the company, it must be subject to a resolution of the shareholders’ meeting. Furthermore, the company’s shareholder/actual controller and the shareholders actually controlled by such person shall abstain from voting, and the resolution requires approval by more than half of the voting rights held by non-related shareholders. This article externalizes the validity of the company’s internal resolution act and clarifies the obligation of the guarantee counterparty to review, so as to curb the harm caused by the company’s ultra vires guarantee.

In the second-instance case of Wei XX, Wang X v. Xi’an XXX Company, Gansu XXX Company, et al. regarding loan contract disputes (Xi’an Intermediate People’s Court, Shaanxi Province, (2024) Shaan 01 Min Zhong No. 22429), the court held: Wang X, as a shareholder of that company, held 80% of the equity. However, when a resolution was to be passed on whether the company would provide a guarantee for Wang X’s personal debt, Wang X had no voting rights under the relevant legal provisions. Wei XX claimed that the aforementioned shareholders’ meeting resolution was actually formed on May 30, 2023, but the evidence provided was insufficient to support this claim. Therefore, the court accepted the defense of Shaanxi XX** Company that the aforementioned shareholders’ meeting resolution was invalid and that the company should not bear the guarantee liability.

02

Investment by Means of Capital Increase, All Original Shareholders Signed the Capital Increase Agreement, but There Was No Shareholders’ Meeting Resolution or No Meeting Convened

When a fund invests in a target company by way of capital increase, according to market transaction practices, all original shareholders will generally participate as parties to the capital increase agreement. Therefore, if the capital increase agreement stipulates that the target company bears guarantee liability for the repurchase obligation of the major shareholder or actual controller, such provision is deemed, under Article 8, paragraph 3 of the Guarantee System Interpretation, to be “a guarantee contract signed by shareholders who alone or jointly hold more than two-thirds of the voting rights on the guarantee matter.” It shall be deemed valid.

In the second-instance case of Guokai Development Fund Co., Ltd. v. Yang Li, et al. regarding equity transfer disputes (Beijing High People’s Court (2022) Jing Min Zhong No. 698 Civil Judgment), the court of first instance held:

“Among them, the ‘Pledge Contract’ was signed and sealed by all shareholders of the target company of the pledged equity, which falls under the circumstances not requiring a company resolution. Therefore, the aforementioned contracts shall be deemed valid.

As mentioned above, the pledge guarantee provided to Guokai Fund Company by Hongfu Mining Company, Rongxin Industrial Company, and Jin Rentao under the ‘Pledge Contract’ is also valid.” The court of second instance amended the guarantee liability of Rongxin Industrial Company as follows: Rongxin Industrial Company affixed the legal representative’s name seal and the company seal to the ‘Pledge Contract,’

but there was no evidence proving that Rongxin Industrial Company had passed a shareholders’ meeting or board of directors resolution for the aforementioned external guarantee. Therefore, the legal representative of Rongxin Industrial Company constituted an ultra vires external guarantee. Guokai Fund Company also failed to submit evidence proving that it had exercised reasonable review obligations regarding the relevant company resolution of Rongxin Industrial Company, and thus it was not a good faith counterparty. Consequently, the guarantee act of Rongxin Industrial Company was invalid.

Therefore, where a company provides a guarantee and there are no other grounds for invalidity, even if there is no formal shareholders’ meeting resolution, the company’s guarantee for the actual controller/shareholder is generally considered effective. However, a guarantee provided by a company signed only by the legal representative is generally deemed invalid.

03

The Capital Increase Agreement Lists a Shareholders’ Meeting Resolution as One of the Conditions Precedent for Investment, but the Investor Did Not Obtain the Written Document of the Shareholders’ Meeting Resolution Before Disbursement

Often, when a fund makes an investment, the original shareholders and the fund will pass a shareholders’ meeting resolution on the capital increase matter. However, the specific and detailed repurchase arrangements are often not reflected in the target company’s shareholders’ meeting resolution on the capital increase. This creates a timing gap. If the fund’s repurchase arrangement is directly reflected in the capital increase agreement, since all shareholders signed it, based on the analysis in part (2) above, courts generally find the guarantee valid.

However, another common situation involves the repurchase arrangement with the actual controller/major shareholder being contained in a supplementary agreement separate from the capital increase agreement, signed by the actual controller/major shareholder and the target company. When signing such a supplementary agreement, the clauses generally include a requirement that the target company obtain internal resolution documents for signing the agreement. However, whether the guarantee counterparty has truly fulfilled its duty of care falls within the scope of the judge’s discretion. In the aforementioned Qiang Jingyan & Hanlin case, regarding whether Qiang Jingyan had exercised prudent care and formal review obligations concerning Hanlin Company’s provision of the guarantee having been approved by a shareholders’ meeting resolution,

the review standard applied by the Supreme People’s Court judges was based on the wording of the “Capital Increase Agreement” and the “Supplementary Agreement” such as “Hanlin Company has passed a shareholders’ meeting resolution, and the original shareholders agree to this capital increase; each party has completed its internal procedures to ensure that it has all the rights to enter into this agreement; the authorized representatives of each party have obtained due authorization from their respective parties,” etc. This case occurred before the Civil Code and the Guarantee System Interpretation took effect. To date, except for the circumstances specified in Article 8 of the Guarantee System Interpretation, the general rule is that a shareholders’ meeting resolution must be issued in accordance with Article 15 of the Company Law; otherwise, the company’s guarantee is invalid. See, for example, the second-instance civil judgment in Liu XX, Taipusiqi XX Company, et al. civil dispute (second instance) (Inner Mongolia Autonomous Region Xilin Gol League Intermediate People’s Court (2024) Nei 25 Min Zhong No. 2132, decided on November 29, 2024).

04

Subsequent Supplementary Agreement Signed Between the Investor and the Actual Controller/Major Shareholder Amending the Repurchase Terms, with the Company Continuing to Bear Guarantee Liability for the Actual Controller/Major Shareholder’s Repurchase Obligation

When the conditions triggering the fund’s equity repurchase occur, in order to maintain the target company’s ability to continue operations, fund investors often negotiate with the target company to update the repurchase trigger conditions. The final negotiated result is usually stipulated in a supplementary agreement. Such supplementary agreements often cannot be signed by all shareholders at the same time, which is an aspect frequently overlooked by funds during post-investment management.

Because this effectively changes the terms of the main contract for which the guarantee is provided, whether the company’s guarantee remains effective or whether the newly signed company guarantee is effective will be highly controversial. At this point, the fund may face a significant risk of being unable to hold the company liable for the actual controller/major shareholder’s repurchase obligation.

PART/ 04

Suggestions and Countermeasures – From the Investor’s Perspective

(1) When investing by way of equity transfer, the target company’s guarantee obligation must be supported by a shareholders’ meeting resolution of the target company.

(2) Before disbursing the capital increase price, the fund should verify each condition precedent for payment one by one, and ensure that all relevant documents are prepared and collected.

(3) When amending the aforementioned repurchase terms by means of a supplementary agreement, special attention should be paid to whether the repurchase content increases the liability of the guarantor, i.e., the target company. For the sake of caution, the fund should still require the target company to resubmit the matter to the shareholders’ meeting for approval.

(4) To the extent possible, the legal representative of the target company should be the signatory to the agreement.

In cases where the company provides a guarantee without a shareholders’ meeting resolution, and the guaranteed party is neither a shareholder nor the legal representative of the company, the company, as the guarantor, is not at fault and bears no liability; the creditor is not in good faith and is at fault. See the second-instance civil judgment in Liu XX, Taipusiqi XX Company, et al. civil dispute (second instance) (Inner Mongolia Autonomous Region Xilin Gol League Intermediate People’s Court (2024) Nei 25 Min Zhong No. 2132, decided on November 29, 2024).

At the same time, if the legal representative of the target company signed the guarantee contract, and there is no shareholders’ meeting resolution, the court will examine whether the legal representative exceeded his authority in representing the company. If the legal representative acted ultra vires on behalf of the company and the company is the guarantor, the company is at fault. The compensation liability borne by the company shall not exceed one-half of the portion of the debt that the debtor cannot discharge. Courts often rule at the upper limit of one-half in such cases. See the first-instance civil judgment in XX Bank Co., Ltd. Xi’an Branch v. Y Tourism Investment Group Co., Ltd., Z Real Estate Development Co., Ltd., et al. regarding financial loan contract disputes (Xi’an Intermediate People’s Court, Shaanxi Province (2024) Shaan 01 Min Chu No. 204, decided on August 9, 2024).

Therefore, when investment risks may materialize, to protect the investor’s interests as much as possible, if holding the target company liable for compensation for the repurchase obligation is not feasible, as a fallback, the fund should try to secure compensation liability of the target company capped at one-half. The key point lies in the legal representative signing the guarantee contract on behalf of the target company.

Wei Yun

Contact email: weiyun@longanlaw.com

Guo Hong

Contact email: guohong@longanlaw.com